An Investment for All Markets

Stock investors keep taking it on the chin. Meanwhile, bond investors keep on smiling their way through the collapsing market, despite a downturn in January. Wouldn't you like to find some way to have the protection that bonds have provided throughout the bear market while still retaining some of the upside of stocks?

There is a way to have your cake and eat it too. Convertible securities combine some of the features of stocks and bonds, giving you the chance to benefit when share prices rise while not leaving you completely exposed to the downside of falling stocks. Convertibles certainly have plenty of risk, but recently, some convertibles have held up far better than the stock market as a whole.

How convertibles work
Convertible securities typically come in the form of either bonds or preferred stock, placing them above common shares in the hierarchy of the corporate capital structure. Most convertibles are structured as income securities, making regular interest or dividend payments one, two, or four times per year. Like most bonds, they usually have a certain maturity date, after which time the issuing company promises to pay back the amount of the bond.

What sets convertibles apart, however, is the conversion option. Depending on the exact terms of the convertible security, investors can exchange their securities at certain times and receive shares of common stock. The fact that you don't have to convert if you don't want to means that you get the best of both worlds. If share prices rise so that converting would make you a profit, you can -- otherwise, you can just have the company pay you your money back at maturity.

Going with funds
Unfortunately, as easy as it is to buy and sell regular stock, it can be a lot more difficult to buy convertible securities directly. Some trade as preferred shares on the same major stock exchanges that offer common stocks, but convertible bonds present the same challenges that most bond trading poses for small investors. Because of those difficulties, you may want to focus on mutual funds that specialize in convertibles.

Below are some strong performers in the convertible security fund category:

Source: Morningstar. *10-year returns as of Jan. 31, 2009.

You'll quickly notice that as a defensive play, convertible securities didn't exactly wipe up the floor in 2008. Many of these funds suffered losses nearly as severe as the overall stock market's 38% drop. Longer-term, however, even modest positive returns over the past decade have been sufficient to beat the losing S&P 500, which has fallen an average of 2.6% each year, by a significant margin.

Risks and rewards
Before you go with convertible securities, though, you should be aware of their risks:

• Although convertibles often pay income, they usually bear a lower interest rate or dividend yield than you could get with a regular bond. In effect, you're paying for the equity kicker by giving up some income.
• Convertible securities aren't immune from being completely wiped out in a bankruptcy proceeding. Just because they're higher up in the capital structure doesn't mean they're senior enough to be guaranteed a payout no matter what.
• Beware of so-called payment-in-kind convertibles. These securities don't make cash interest payments at first -- instead, they simply issue more securities. You might get a better rate on them, but the lack of cash can indicate liquidity problems that you don't want to deal with.

Despite the risks, however, convertible securities can be a good way to dial down the overall market risk in your portfolio. Especially now, you may find the defensive stance that convertibles can give you particularly useful.

For more on combining income with growth, read about:

• The next three dividend dynamos.
• Buy stocks just like this one.
• Why you should get Warren Buffett in your corner.